Financial market legislation implemented in response to the financial crisis to reduce market risks is now impacting the way prime brokers service the hedge fund industry.
Banking regulations, the Dodd-Frank Act and Basel III have a direct impact on prime brokers’ ability to finance and maintain hedge funds assets on their balance sheet.
This means prime brokers, who are crucial to the success of hedge funds by providing not only execution and custody service, but also securities lending and margin financing, are taking a closer look at their relationship with hedge fund clients when assessing how they are managing their balance sheet as well as their capital requirements.
According to Ernst & Young’s 2015 Global Hedge Fund and Investor Survey, this has resulted in higher trading fees and other changes to the industry’s business relationships, which places additional pressure on a fund’s margins and leads managers to seek new growth strategies.
Nearly a third of managers have already experienced higher prices, according to the EY survey, and depending on the nature of a manager’s portfolio and financing needs, the price increase ranged from 10 percent to 40 percent.
At the Ernst & Young Hedge Fund Symposium in Cayman in December, EY partner Marcello Calleja emphasized that the price increases are important because they are eroding a manager’s trading economics, which has an impact on the investor’s returns.
Managers are seeing a strain on performance, and financing is drying up. “This has a knock-on effect on liquidity in the markets. Cash management is a lot more challenging and is putting additional pressure on the treasury function in hedge funds,” Calleja said.
Kara Saxon, managing director in the U.S. prime brokerage business of Goldman Sachs, confirmed that prime brokers have started to pay close attention to the business mix of their clients.
“Regulation has caused us to reserve and use additional firm capital to run our business. Depending on the amount of leverage that we are providing clients, depending on the asset classes that we are providing that leverage on, we need to reserve additional capital beyond what we have in the past.”
Because prime brokerage is a balance sheet-intensive business, taking up 25 percent to 30 percent of Goldman’s balance sheet, balance sheet funding and capital requirements, the prime broker is now evaluating clients in terms of their return on assets.
“It is really taking a look at the client’s P&L over the balance sheet they are using at Goldman Sachs,” she said.
The measure relates the revenues from prime brokerage, swaps, execution and financing to the balance sheet intensity of the client. In addition, Goldman even attempts to break down return on equity to the client level.
This type of analysis favors certain trading strategies over others, the EY survey found.
“Strategies that require a sizeable portion of a prime’s balance sheet involve the financing of less liquid assets or trading activity that has historically been less profitable for the prime brokers were most dramatically impacted this past year,” said Calleja.
In contrast, managers who traded a higher volume of high quality liquid assets were not re-priced as often.
Saxon agreed that certain mixes of business are more attractive to prime brokers than others.
Quantitative trading strategies, for instance, bring a lot of execution business, they trade in very liquid equities and have a good balance of long and short positions, which results in a netting benefit for the prime broker, who can cover one client’s long with another client’s short, thereby reducing the impact on the balance sheet, she explained.
Fixed income and distressed assets, in contrast, are less attractive due to their cost of funding and in terms of additional capital requirements.
While brokers are responding by asking managers to concentrate more business with them, which should result in fewer multi-prime broker relationships for managers, the EY survey found that the opposite occurred.
Managers increased their relationships to diversify their exposure and manage their counterparty capacity risk by taking advantage of new market entrants.
“Some brokers have been unable to provide some of their largest clients with financing because they don’t have the capacity to do so on their own balance sheet,” Calleja said. “So it is not surprising that managers seek more options by adding relationships.”
Consequently, the survey results also reflected that more managers are seeking financing from nontraditional sources, such as sovereign wealth funds, other institutional investors, custodians and even other hedge funds to obtain financing.
Working with clients
However, prime brokers are not just aiming to increase a client’s revenue number, increase spread or charge additional fees to maximize their relationship and reduce costs, Saxon said. The aim is also to improve balance sheet efficiency, for example by talking to clients about balancing their short to debit mix, convincing them to trade synthetics rather than physical securities, and by offering services that sweep excess cash to Goldman’s asset management arm.
Clients can also improve their debits by buying U.S. treasuries. “It enables Goldman to then re-hypothecate the treasury which we then post to a lender and use as collateral instead of posting cash to a lender,” Saxon explained. “That is a very efficient balance sheet transaction for us.”
Outsourcing and growth
Due to the pressure price increases and changing prime broker relationships have on the margins, managers have to consider outsourcing even more of their non-core functions.
While growth remains the top strategic priority, fewer funds are attempting to achieve this growth with new products, according to the survey. The most significant decline was observed in registered funds and UCITS.
“I think the simple explanation here is that the industry simply overestimated the initial demand for these types of products. Industry stats indicate that inflows into these liquid alts peaked back in 2013 and this year we are projecting inflows at the lowest level since 2008,” EY partner Mike Mannisto told delegates.
Although managers found that new products were helpful with brand recognition and investors were generally satisfied with the product experience, Mannisto said, the impact of new products on a funds resources, operations and ultimately margins was often negative.
New products add to reporting and process complexity that weighed on the fund’s infrastructure.
“Many of these new products carry very heavy regulatory burdens,” he added.